I am a Tax Partner in WithumSmith+Brown’s National Tax Service Group and the founding father of the firm's Aspen, Colorado office. I am a CPA licensed in Colorado and New Jersey, and hold a Masters in Taxation from the University of Denver. My specialty is corporate and partnership taxation, with an emphasis on complex mergers and acquisitions structuring. In the past year, I co-authored CCH's "CCH Expert Treatise Library: Corporations Filing Consolidated Returns," was awarded the Tax Adviser's "Best Article Award" for a piece titled "S Corporation Shareholder Compensation: How Much is Enough?" and was named to the CPA Practice Advisor's "40 Under 40."

In my free time, I enjoy driving around in a van with my dog Maci, solving mysteries. I have been known to finish the New York Times Sunday crossword puzzle in less than 7 minutes, only to go back and do it again using only synonyms. I invented wool, but am so modest I allow sheep to take the credit. Dabbling in the culinary arts, I have won every Chili Cook-Off I ever entered, and several I haven’t. Lastly, and perhaps most notably, I once sang the national anthem at a World Series baseball game, though I was not in the vicinity of the microphone at the time.

Tax Geek Tuesday: Hot Assets And The Sale Of Partnership Interests

As you might imagine, clients generally are wholly unaware that Section 751 exists. By and large, most people assume that the sale of a partnership interest results in the exact same tax consequences as those arising from the sale of stock – namely, advantageous long-term capital gain. The responsibility falls to us then, as the tax advisors, to understand the full sting of Section 751 and advise our clients accordingly. And as the ensuing example illustrates, the consequences can be far worse than merely the recharacterization of capital gain to ordinary income.

Assume the same balance sheet as in our previous example, only A’s outside basis in the one-third interest is $280, which includes A’s $90 share of the X Co. liabilities.

Step 1: Determine the total gain on the sale

In this case, A’s amount realized remains $310 ($220 fair market value of the equity interest plus A’s $90 share of the X Co. liabilities). A’s tax basis, as provided above, is $280. Thus, A recognizes $30 of total gain on the sale.

Step 2: Determine the ordinary income component

The balance sheet of X Co. has not changed. As a result, A’s share of the ordinary income component remains exactly what it was in the previous example–$30 attributable to the cash-basis receivables, $10 attributable to the inventory, and $90 attributable to depreciation recapture.

With total gain on the sale of $30, you may be tempted to think that A’s potential ordinary income is limited to the Step 1 gain of $30. But you’d be wrong. Section 751 provides that A’s total ordinary income component must be recognized as ordinary income, even if A’s total gain on the sale is less than this amount. Thus, even though A’s total gain is only $30, he still must recognize $130 of ordinary income on the sale.

Step 3: “Plug” the difference to capital gain

A recognized $30 of gain on the sale of his one-third interest in X Co. Under Step 2, A was forced to recognize $130 of ordinary income. Under Step 3, A is entitled to “plug” the difference necessary to arrive back at his Step 1 total gain by recognizing a $100 long-term capital loss.

But what’s the problem? On his individual return, A will recognize $130 of ordinary income and pay tax at rates as high as 43.4% on the income. A’s also recognizes a $100 capital loss; this loss may be limited, however, by Section 1211. To the extent A has no other capital gains, he can use up to $3,000 of net capital loss in the current year, with any excess carried forward to future years.

As a result, if A does not have any current capital gains and we add some zeroes to our numbers, we can see how A will get painfully whipsawed. For example, A would be required by Section 751 to recognize $130,000 of ordinary income and take a plugged $100,000 long-term capital loss, only $3,000 of which would be currently useable. Try explaining that one to a client.

Effect of Cash-Basis Payables

Explain the purpose and consequences of Section 751 to a client, and you will invariably get this response:

“But why do I have to pick up the ordinary income attributable to my cash-basis receivables if I also have cash-basis payables in the same amount?”

And that’s a damned good question. Unfortunately, however, the selling partner’s determination of Section 751 ordinary income is unaffected by the presence of any cash-basis payables. As a result, the taxpayer may find themselves in the rather unequitable position of having to recognize his share of the partnership’s cash-basis receivables as ordinary income even though the partnership has cash-basis payables of the same amount.

Now, between you, me and the lamppost, I have known some people to have taken the position that the partnership’s cash-basis payables were so closely linked to the cash-basis receivables that they impacted the fair market value of the receivables, thus reducing the ordinary income component under Section 751. How that worked out for them, I can’t say.

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